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Want to profit from high oil refining margins? You can almost run your own oil refinery, hedging your output through three ETFs that track crude oil, heating oil, and gasoline. At a very basic level, refining oil is easy to understand. You buy crude oil and refine it into various products. If you sell those products for more than the cost of the crude oil, you make a profit.

Although there are many nuances to this business - different grades of oil, seasonal demand patterns, and dozens of different refined products each with their own price - there's a simple way to approximate the profit margin for refining oil. It's called the "crack spread," which gets its name from the refining process itself because you "crack" complex crude hydrocarbon molecules into usable products.

There are several versions of this spread. One popular spread is called the 3:2:1 crack spread. Here's how it works. Three barrels of WTI crude oil yield one barrel of heating oil and two barrels of gasoline. But the easy way of calculating it is to divide by three. Assume that one barrel of crude oil (42 gallons) yields one-third of a barrel of heating oil (14 gallons) and two-thirds of a barrel of gasoline (28 gallons) as shown here:

Calculating the spread

Here how this 3:2:1 crack spread was priced as of Friday, February 3

WTI Crude oil: $97.84 per barrel

Heating oil: 3.114 per gallon x 14 gallons = $43.59

Gasoline: 2.914 per gallon x 28 gallons = $81.59

Total heating oil and gasoline revenues: $43.59 + $81.59 = $125.18

Less cost of crude oil: $97.84

NET PROFIT = $27.34

Is that a lot? Let's take a look at that spread over the past 18 months.

Yeah, that seems like a lot, but it's certainly not as much as it was in September.

Three ETFs to profit from the crack spread

When the spread is going up, you'd do well to be buying gasoline and heating oil, while simultaneously selling crude oil.

You can do this through trading three ETFs in the 3:2:1 ratio outlined above. These include

  • US Heating Oil Fund (NYSEARCA:UHN)
  • US Gasoline Fund (NYSEARCA:UGA)
  • US Oil Fund (NYSEARCA:USO)

These ETFs hold nearby futures contracts, so if you think the spread is going to go up, you might go long the spread with the following trade:

Long the crack spread

  • Buy $10,000 of UHN
  • Buy $20,000 of UGA
  • Sell $30,000 of USO

I would adjust this position monthly to maintain that 3:2:1 ratio.

If you think the spread is going down instead -- as it did in September last year, you'd benefit from shorting the spread with the opposite trade:

Short the crack spread

  • Sell $10,000 of UHN
  • Sell $20,000 of UGA
  • Buy $30,000 of USO

Riding the crack spread for fun and profit

How would this approach have performed over the past year? Well we can certainly assume that none of us can pick an exact top or bottom. So let's look at the spread chart again and make some assumptions about where going long or short this spread might have made sense based on trends at the time.

On February 1, 2011 you note the spread is rising, so you buy $10,000 of UHN and $20,000 of UGA while shorting $30,000 of USO. You'd treat each month as a separate trade so you can maintain the 3:2:1 ratio.

On October 3, the spread is appears to be declining. Now you short the crack spread by buying crude oil and selling heating oil and gasoline, once again resetting your position each month to stay within the 3:2:1 ratio.

Finally, on January 3, 2012, you switch and go long the spread once again, closing position on February 1.

This table shows the results for each month's trade, the profit of each position, and the net results.

The months highlighted in yellow were trades for being long the spread. The ones in purple are months trading the spread from the short side.

Here's a chart showing the net profit of your positions throughout the year.

No it's not perfect, but when the spread is trending, you can make a fairly decent gain. The profits really rose as the spread switched direction in October.

If you prefer, you might be able to use options for the USO part of your spread. These options are fairly liquid, but there are no options for UHN, and UGA options are too thinly traded to be of much use.

You don't need to be in the oil business to capitalize on the crack spread. Easy? Well no, nothing in the oil market is easy, but this could be a pretty reliable ongoing trade if you follow the trend.

Source: Run Your Own Profitable Oil Refinery By Hedging 3 ETFs